Apple's interest in Beats Electronics stirs speculation

Beats Electronics, a private company, reportedly had revenue of more than $1 billion last year. (David Ebener / European Pressphoto Agency)

More than a decade after it revolutionized the music industry with the launch of iTunes, Apple Inc. remains the world's largest music retailer and one of the most recognized brands.

So why, exactly, does it need to buy Beats Electronics' headphone and streaming music service for $3.2 billion?

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Since word of the talks first leaked Thursday, no single consensus has emerged to provide a clear motive for what would be the largest acquisition in Apple's history.

"My big reaction is, 'Why?'" said Carl Howe, a longtime Apple watcher and analyst at Yankee Group. "It's clear that Apple doesn't do stuff like this for no reason. They don't do random M&A [mergers and acquisitions]. There must be some strategic reason we don't know about."

While the deal is groundbreaking for Apple, which has been relatively conservative in its acquisitions, it's ho-hum by Silicon Valley standards. Beats Electronics, a private company, reportedly had revenue of more than $1 billion last year. Paying three times that to buy the company, analysts noted, is a pretty low risk compared with Facebook buying messaging start-up WhatsApp for $19 billion.

Still, the deal — eight times larger than anything Apple has acquired before — is so out of character for the Cupertino tech giant that many Apple analysts said they would believe it only when they saw an actual press release announcing a deal from the company. On Thursday, three sources close to the deal confirmed the talks and the potential value of the deal.

Peter Csathy, chief executive of Manatt Digital Media Ventures, believes the acquisition is a good one because at a high level, both companies have similar business models and premium mind-sets.

"Let's put aside the price tag," Csathy said. "The marriage makes perfect sense. They are both hardware companies that use music and media to drive more hardware sales."

When the talks first became public, the presumption from many corners was that Apple wanted the Beats Music streaming service, which launched this year.

Apple's iTunes business remains a giant force. When the iTunes store first launched, music labels and publishers worried that it was eroding sales of more profitable formats like compact discs. These days, Apple still accounts for 90% of digital downloads in the U.S. And in recent years, it's dramatically expanded the availability of the iTunes stores to dozens of new countries.

More recently, streaming services like Spotify and Pandora have surged in popularity. According to Recording Industry Assn. of America statistics for 2013, digital downloads represented 40% of music industry revenue, while streaming and subscription services had grown to 28% of revenue. According to Nielsen SoundScan, 2014 sales of digital tracks as of May 4 are down 12% from a year earlier.

Last year, Apple launched iTunes Radio, a free, ad-supported service for iPhone users. However, Apple found itself scrambling to close the deals with music labels and publishers in the final days before it was scheduled to unveil the new service at its developers conference. Analysts said Apple was losing some if its influence with music companies as iTunes accounted for a falling share of revenue.

A few weeks after the service launched, Apple said on an earnings call last October that iTunes Radio had 20 million unique listeners. The company has not updated that number in the two successive earnings calls.

Apple has also been pushing on other fronts to continue to deepen its relationships with artists and labels. For the first time in March, Apple brought the iTunes Festival, which it holds every year in the United Kingdom, to the U.S., to the South by Southwest Conference in Austin, Texas. Apple Chief Executive Tim Cook recently attended the prestigious Clive Davis pre-Grammy dinner party with Universal Music Group Chairman and Chief Executive Lucian Grainge.

And in December, Beyonce released a surprise new album exclusively on iTunes that became the online store's fastest-selling album ever. Some analysts wondered whether having music mogul Jimmy Iovine and rapper Dre in the Apple fold would help the company cultivate even more unique deals.

Meanwhile, in January, Beats Music launched with tremendous hype and marketing. Beats Music charges $10 a month for access to its song library online. The company also partnered with AT&T to offer a $15-a-month family plan. It has not disclosed its number of subscribers.

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The service received strong reviews for its technology that adjusted music selections based on the users' mood and its well-designed interface. But the service got off to a slow start, missing its early targets. It only began to gain steam, analysts said, when Beats agreed to start selling subscriptions through the iTunes Store. That meant giving 30% of all sales to Apple.

Still, plenty of other analysts were skeptical that streaming is a big factor in the deal. They noted that with 800 iTunes users and plenty of technical knowledge, Apple should be able to launch its own streaming service. The bigger problem, they say, is that while streaming revenue is growing, profits are not. Why should Apple be in a hurry to cast aside more profitable downloads?

That turns the focus to Beats' headphone and speaker business. Some analysts see the headphones as not just a nice bit of additional revenue for Apple but also a way to learn more about the emerging wearable computer business. And if people sprinkle Beats wireless speakers throughout the house, perhaps that could be used to drive more iTunes sales.